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Wednesday, December 20, 2017

The Role of Bank Reserves, I

Many people
misunderstand the role that reserves play in banking.This is not unusual, for most people do not
understand the role of banking.They
tend to confuse the different types of banks, and thus the unique function that
each one of them performs.

"The money isn't here!"

Reserves are
actually only critical for commercial banks.Banks of deposit shouldn’t have this as an issue since they can only
make loans out of capitalization and deposits.Strictly speaking, a bank of deposit doesn’t even have reserves.Everything it
has can (in theory, anyway) be loaned out — remember the scene in It’s A Wonderful Life when Jimmy Stewart’s
character explains that the money in the savings and loan (a type of bank of
deposit) isn’t in the vault?

No, the money is
in so-and-so’s home, taxi, or business.There is only enough cash on hand to meet the daily transactions demand for
cash — and transactions cash isn’t really reserve
cash (except legally), because it is expected to be paid out and replenished in
the course of daily business.It’s
really working capital of the bank, not a reserve.

Strictly
speaking, reserves consist of cash in the form of the accepted reserve currency
or cash equivalents of the reserve currency, such as a demand deposit the
commercial bank maintains at the central bank.These are used to redeem the bank’s obligations that come in “ahead of
schedule” (so to speak).

Reichsloanbank note, large denominations only.

In theory, it is
possible for a commercial bank to function without any reserves at all; a “loan
bank” does this . . . which is why you seldom see a pure commercial loan bank
these days.(The only modern one of
which we’re aware, in fact, was the Reichsloanbank of the German Empire, which
appears to have ceased normal operations in 1914, and gave its last gasp with
the end of the hyperinflation in 1924.)

A loan bank — a
bank of discount — only makes loans
and issues promissory notes.It only
accepts its own promissory notes or equivalents in repayment of the loans it
makes, so it incurs no liabilities subject to redemption in the reserve
currency, just its own promissory notes that are cancelled by repayment of its
own outstanding loans.There are no
deposits, so there are no depositors needing to cash checks, and the bank’s
promissory notes (usually only in large denominations) are only accepted in
payment of loans.Regular commercial
banks will accept the loan bank’s promissory notes for deposit, but will then
pay them out again — to a borrower who needs them to repay a loan from the loan
bank.

Dr. Harold G. Moulton

Of course, that
is the theory, and reality always intrudes.That being the case, a commercial needs cash reserves to meet the demand
for cash when individuals and other banks accept the commercial bank’s
obligations and want the reserve currency, not more of the commercial bank’s
obligations, for whatever reason.Thus,
as Moulton explained,

In fact, however, some individuals would wish to withdraw
a portion of their deposit accounts in the form of actual cash, because some of
their needs could be more conveniently met with actual cash than by means of
checks. Hence, it is essential that the bank be prepared to meet such demands
for cash as may arise. The primary problem is to determine what percentage of
outstanding deposits at any one time is likely to be called for in the form of
actual cash.

Let us assume that experience shows that not more than
25 percent is ever demanded in cash. Under these circumstances it would be
possible for the bank to make loans and create new deposit accounts not only up
to the full amount of the capital of one million dollars, but much beyond that
amount. . . . . The balance sheet would then read:

It is apparent that, to the extent that checks are
presented for cash, the cash reserve of $900,000 will be drawn down. But this
reserve of cash will also be periodically replenished by the repayment of loans
falling due — or by the actual deposits of cash made by new customers. There
will be a more or less continuous outflow of cash from the bank and also a more
or less continuous inflow. The primary task of the managers of such a bank is
to schedule the maturities of the loans in such a way as to bring a steady
backflow of funds to the bank. In this connection, allowance will, of course,
have to be made for known seasonal variations in the demand for cash.

Let us now complicate the problem by assuming that
there are two banks in this community. When bank No. 1 makes a loan of $100,000
to A, who writes a check in favor of B, the latter now deposits the check not
in the same bank but in bank No. 2. This second bank will present the check to
the first bank for payment. Now in the event that the first bank had not, on
the same day, received for deposit checks which had been drawn against bank No.
2, it would be necessary for this bank to turn over $100,000 in cash to the
second bank. But under the conditions which would gradually develop in any
community, both banks would be making loans simultaneously, and each would be
receiving checks drawn against the other bank. Accordingly, there are always
substantial offsets; and it is only the balance
owed by one bank to the other which has to be settled in actual cash.